Idiosyncratic Risk and Expected Returns of Equity Real Estate Investment Trusts

Abstract

Executive Summary. Researchers have extensively debated the relevance of idiosyncratic risk in determining asset returns. Merton (1987) suggests that investors would consider idiosyncratic risk relevant when there is incomplete information for fully diversifying their portfolios. REITs possess characteristics of information opacity and represent a unique case for testing Merton's hypothesis. Using firm-level data of equity real estate investment trusts (EREITs), we find a significant positive relation between idiosyncratic volatility and expected EREIT returns. The positive relation persists even after controlling for firm characteristics and variables that are typically related to idiosyncratic volatility. The result supports the hypothesis of Merton and implies that some segments of the REIT industry might be informationally inefficient. When we exclude small, low-priced, and illiquid EREITs from the sample, the relation between idiosyncratic volatility and expected EREIT returns becomes insignificant. The findings may have significant implications for investing in REITs.